When the Tax Cuts and Jobs Act was signed in late 2017, real estate developers and investors were thrilled to discover that it added new provisions to the Internal Revenue Code that provide tax incentives to investors who want to reinvest unrealized capital gains on a tax-deferred basis. Specifically, investors can defer and reduce capital gains taxes by putting capital gains into “Qualified Opportunity Funds” that are dedicated to investing in businesses operating in low-income communities designated as “Qualified Opportunity Zones,” as shown on this interactive map.
The Department of the Treasury recently released proposed regulations that provide additional guidance with respect to how these tax benefits will work. This article provides an overview of the Act and the proposed regulations, which are expected to attract $100 billion in investment according to Treasury Secretary Steven Mnuchin.
Tax Benefits Provided by the Opportunity Zone Regulations
The tax benefits provided by the Opportunity Zone regulations include:
- A deferral of inclusion in gross taxable income for capital gains reinvested in a Qualified Opportunity Fund (a “Fund”).The deferred gain must be recognized on the earlier of the date on which the Fund investment is disposed of or December 31, 2026.
- A permanent reduction in capital gains included in gross taxable income for gains reinvested in a Fund for longer than five years.For investments in a Qualified Opportunity Fund held longer than five years, upon sale of the assets, taxpayers may exclude 10% of the deferred gain from inclusion in income. For investments held longer than seven years, taxpayers may exclude a total of 15% of the deferred gain from inclusion in income.
- A permanent, total exclusion from gross taxable income of capital gains invested in a Fund after the investment is held for 10 years.To obtain this total exclusion, the taxpayer can elect to increase the basis of the investment to the fair market value of the investment on the date it is disposed of. The proposed regulations clarify that, even though the Qualified Opportunity Zone (“Zone”) designations are set to expire on December 31, 2028, taxpayers can still make the election for this benefit until December 31, 2047.
The Act provides that investors can defer taxable gains on the sale or exchange of any property, regardless of that property’s location, by investing the gains in a Fund within 180 days of the disposition of the property to a person who is not “related” to the transferor/taxpayer. The proposed regulations provide that the 180-day period generally begins to run on the date on which the gain would be recognized for tax purposes, and they outline examples of how the timing would work.
The proposed regulations also provide that, if a subsequent sale of a Fund interest would otherwise trigger inclusion of a gain in income, but the taxpayer makes a new investment of the entire gain into another Fund within another 180 days, then the gain will continue to be deferred. The proposed regulations further describe how deferral of capital gains can be elected either by pass-through entities, or if not, by the underlying partner, shareholder or beneficiary of distributed capital gains.
The Funds operating as the investment vehicles must be organized as corporations or partnerships for the specific purpose of investing in “Qualified Opportunity Zone Property” (“Opportunity Zone Property”), and they must hold at least 90% of their assets in Opportunity Zone Property, as determined by the average percentage of such property held during the taxable year. Failure to meet the 90% requirement results in a penalty for each month of noncompliance. Corporations and partnerships can self-certify as Funds according to the proposed regulations.
Opportunity Zone Property includes (1) qualified opportunity zone stock or partnership interest or (2) “Qualified Opportunity Zone Business Property” (“Zone Business Property”). Qualified opportunity zone stock or partnership interest is either stock in a corporation or ownership interest in a partnership that is a “Qualified Opportunity Zone Business” at the time of issuance and during substantially all of the holding period. These interests must be acquired after December 31, 2017 to demonstrate new investment.
A “Qualified Opportunity Zone Business” (a “Business”) must meet the following requirements:
- “Substantially all” of the tangible property owned or leased by the entity is Opportunity Zone Business Property, as defined below; and
- (a) At least 50% of the total gross income of such entity is derived from the active conduct of a business in a Zone; (b) A substantial portion of the intangible property of such entity is used in the active conduct of a business in a Zone; and (c) Less than 5% of the average of the aggregate unadjusted bases of the property of such entity is attributable to nonqualified financial property, which does not includereasonable amounts of “working capital assets” held in cash, cash equivalents, or debt instruments with a term of 18 months or less; and
- The business is not a private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any store the principal business of which is the sale of alcoholic beverages for consumption off premises.
One of the most widely-reported proposed regulations clarifies the first requirement above by providing that, if at least 70% of a business’s owned or leased tangible property is Zone Business Property, it meets the “substantially all” requirement.
The proposed regulations provide an illustration of the differences in asset requirements of Funds and Businesses:
…consider a [Fund] with $10 million in assets that plans to invest 100 percent of its assets in real property. If it held the real property directly, then at least $9 million (90 percent) of the property must be located within an opportunity zone to satisfy the 90 percent asset test for the [Fund]. If instead, it invests in a subsidiary that then holds real property, then only $7 million (70 percent) of the property must be located within an opportunity zone. In addition, if the Fund only invested $9 million into the subsidiary, which then held 70 percent of its property within an opportunity zone, the investors in the Fund could receive the statutorytax benefits while investing only $6.3 million (63 percent) of its assets within a qualified opportunity zone.
The proposed regulations also include a “safe harbor” provision which provides that “working capital assets” meet the requirements for exclusion from nonqualified financial property for purposes of Section 2(c) above, if (1) there is a written plan that identifies the working capital assets as property held for the acquisition, construction, or substantial improvement of tangible property in a Zone; (2) there is a written schedule consistent with the ordinary start-up of such business which requires the assets to be spent within 31 months of receipt; and (3) the working capital assets are actually used in a manner substantially consistent with the foregoing plan and schedule. The proposed regulations contain detailed examples of how the safe harbor provision works.
Qualifying Underlying Property
“Opportunity Zone Business Property” is tangible property used in the business of a Fund or Business that meets the following requirements:
- The property is acquired after December 31, 2017;
- (a) The “original use” of such property in the Zone commences with the Fund or Business or (b)The Fund or Business “substantially improves” the property by making, during any 30-month period after acquisition, “additions to the basis of the property in the hands of the [Fund/Business which] exceed an amount equal to the adjusted basis of the property at the beginning of the 30-month period…;” and
- During “substantially all” of the Fund or Business’s holding period for such property, “substantially all” of the use of such property is in a Zone.
The proposed regulations address the “substantial-improvement” requirement in Section 2(b) above with respect to buildings purchased in a Zone by specifying that a substantial improvement to such property is measured by the additions to the adjusted basis of the building only, indicating that there is no need to separately substantially improve the land upon which the building is located. In other words, “the basis attributable to land on which such a building sits is not taken into account in determining whether the building has been substantially improved.”
The Treasury also recently released Rev. Rul. 2018-29, which it expects to also reference in future proposed regulations and which reiterates the meaning of “substantial-improvement” as described above. In addition, the opinion indicates that, where a Fund buys land with an existing building in a Zone for the purpose of renovating the building for another purpose, the “original use” of the land and building does not “commence with the Fund,” as described in Section 2(a) above, but tax benefits will still apply if the Fund “substantially improves” the property under Section 2(b) by virtue of the development, providing the following example:
Under the facts of this revenue ruling, [Fund] A purchased Property X, a factory building and the land on which it was located (both wholly within a [Zone]), for $800x with the intent to convert the building into residential rental property. Sixty percent ($480x) of the purchase price for Property X was attributable to the value of the land and forty percent ($320x) was attributable to the value of the building.
Section [2(b)] does not apply to the land on which the factory building is located, but does apply to the building. Because the factory building existed on land within the [Zone] prior to [Fund] A’s purchase of Property X, the building’s original use within the [Zone] did not commence with [Fund] A.
However, under [Section 2(b),] [Fund] A substantially improved Property X because during the 30-month period beginning after the date of [Fund] A’s acquisition of Property X, [Fund] A’s additions to the basis of the factory building ($400x) exceed an amount equal to [Fund] A’s adjusted basis of the building at the beginning of the 30-month period ($320x).
The fact that the cost of the land on which the building is located is not included in [Fund] A’s adjusted basis of the building does not mean that [Fund] A is required to separately substantially improve the land.
Looking Forward – Additional Regulations Will Be Released Later
Technically, any individual investor can create a Qualified Opportunity Fund and receive the tax benefits described above by organizing and self-certifying a qualifying entity and filing the appropriate tax documentation at tax time. However, analysts suggest that it is more likely that institutions will create large, pooled, multiple-asset Funds that will allow individuals to reap tax benefits by investing qualifying money in a Fund without personally managing the investment property.
To that end, the National Council of State Housing Agencies maintains a list of new multiple-asset Funds set up for investing in qualified businesses and property, as shown here.
The proposed regulations indicate that additional regulations or guidance will be released at a later date, including further clarifications of many of the terms in the definition of Zone Business Property. Complete copies of the Internal Revenue Code provisions added by the Tax Cuts and Jobs Act of 2017 are located at 26 U.S.C.S § 1400Z-1 and § 1400Z-2, and the recently proposed regulations are located on the IRS website.
A hearing will be held on the proposed regulations on January 10, 2019. Please contact our office if you have questions about the Opportunity Zones program or other real estate development incentive programs.